Roth Conversions Another Silver Lining in Weak Market
Stocks posted their worst quarter in four years during the third quarter, sliding on fears over slowing growth.
But as with all market sell-offs, there are a few silver linings. While stocks still aren't cheap, they're more attractive than they were a few months ago. The typical company in Morningstar's coverage universe was trading about 10% below our analysts' estimate of fair value, as of early October.
Market weakness also presents opportunities for tax-loss selling. Given that stocks have rallied with few breaks since early 2009, it's a rare buy-and-hold investor whose average cost basis in a core U.S. equity fund is below the fund's current price. But individual-stock investors may be able to identify securities that are trading below their purchase prices. Even low-turnover fund investors may be able to identify tax-loss sale opportunities in narrower categories such as emerging markets, energy, or commodities. Investors using the specific-share-identification method for cost basis may also be able to cherry-pick more recently purchased, higher-priced lots of a given stock or fund, booking a tax loss on those securities while leaving lower-cost-basis shares intact. (Such flexibility is they key reason why I'm such a big fan of specific share identification relative to the other cost-basis-election methods.) Those tax losses can be used to offset capital gains elsewhere in the portfolio or, if there are none, up to $3,000 in ordinary income.
Yet another potential maneuver to explore in the wake of declining asset prices is the conversion of traditional IRA assets to Roth. Investors who convert traditional IRA assets to Roth will owe taxes on any never-been-taxed assets in the traditional IRA (pretax contributions and investment earnings). That means that conversions are generally more desirable when either the investor's own tax rate is at a low ebb or when the securities in the portfolio are--or ideally both. Thus, market declines can present an opportunity to reduce the taxes on a conversion that an investor wanted to do anyway. Likewise, a market decline can provide an opportunity to revisit conversions done in the recent past; it may be advantageous to undo the conversion via a method called a recharacterization, thereby lessening the tax burden.
If converting traditional IRA assets to Roth is on your to-do list, or you made a conversion earlier this year, here are some of the key questions to ask.
Does a Roth Even Makes Sense?
Roth IRA assets are a great example of deferred gratification. You'll pay taxes on the money before it goes into a Roth account; but once it's in there, it enjoys tax-free compounding, and withdrawals are also tax-free. By contrast, traditional IRA assets are taxed at your ordinary income tax rate upon withdrawal, though you may be able to make a deductible contribution if your income falls below the thresholds outlined here.
The ability to take tax-free withdrawals in retirement will be particularly advantageous for those who expect to be in a higher tax bracket in retirement than they are today; if that's the case, it's better to pay taxes before you put money into the account (as you do with Roth assets) than when you take it out (as you do with traditional IRAs). Seeking Roth treatment can also make sense if you don't expect to need all or part of your IRA assets during your lifetime. Importantly, Roth assets aren't subject to required minimum distributions (RMDs) whereas traditional IRA assets are. For people who expect that their IRA assets will go mainly or in part to their heirs and don't want to bother with RMDs, Roth assets tend to make a lot of sense. Being able to dodge RMDs also gives retirees an invaluable level of control over their tax situations and should allow them to reduce their taxes in retirement, whereas RMD-subject investors have much less control.
Yet, as much as we've all been inculcated in the virtues of Roths, they won't add up for everyone. Those who expect to be in a lower tax bracket in retirement than when they are contributing to a Roth (or converting traditional IRA assets to Roth) will tend not to benefit from having Roth assets; such individuals are also likely to need their IRA assets in retirement, period, so the ability to dodge RMDs won't be a benefit. Moreover, individuals who are eligible for a tax deduction on an IRA but go Roth instead may push themselves into a higher tax bracket, disqualifying themselves for valuable credits and deductions in the process.
For many individuals and families, the signals about whether to go Roth or retain traditional IRA assets are mixed. In that case, it can be sensible to do both--retain some traditional IRA assets while contributing to or converting some assets to a Roth as well.
Would Serial Conversions Help Lessen the Tax Impact?
For investors who already have traditional IRA assets and have decided that they'd like to get some of those assets into the Roth column, conducting those conversions over a period of years can help them reduce the conversion-related taxes due. A tax advisor well versed in investment-related taxes can help coach you on how to convert just enough to avoid pushing yourself into a higher tax bracket.
Taking stock of your total financial situation is key here, however. For example, even though your traditional IRA balance may be depressed for one reason or another, you may also have received a big bonus earlier in the year, plumping up your income and making the conversion more costly than it might be if you waited. Be sure to consider every aspect of your financial life--not just asset prices--when deciding whether to convert.
Should You Revisit Past Conversions?
Because there are so many moving parts in the decision about whether to convert, financial and tax advisors often counsel investors to take advantage of the escape hatch offered to IRA converters--a tool called recharacterization. If a conversion to a Roth turns out to have been ill-advised--because the securities in the IRA subsequently fell or because the conversion-related tax bill was higher than expected--the investor can effectively undo the conversion and its related tax bill by recharacterizing. The investor can then convert that traditional IRA back to a Roth when it's more advantageous to do so.
That tool could be of particular use to investors who converted IRA assets earlier this year but have seen them decline in value subsequently. For example, say an investor converted his IRA, consisting of a $100,000 stake in Vanguard Emerging Markets Stock Index (VEIEX), in early January. He'd owe $25,000 in taxes on that conversion, assuming he's in the 25% tax bracket. But if he were to recharacterize that position and convert back to Roth again, the tax burden would be only $21,250 (the position's current value of $85,000 multiplied by his 25% tax bracket).
Should You Make a Habit of It?
Because a conversion can be so readily undone with a recharacterization, financial planner Allan Roth, a fee-only hourly financial planner and founder of Wealth Logic in Colorado Springs, CO, views the initial conversion as a sort of "free look." If the market takes off afterward, the investor will have paid less in taxes than she would have by waiting. But if the market drops sharply, the investor has the option to undo the conversion by recharacterizing.
For this reason, Roth counsels clients to take advantage of serial conversions and recharacterizations. The basic strategy involves converting IRA assets earlier in the year, then potentially recharacterizing back to a traditional IRA and converting back to Roth later on, if those maneuvers lessen the tax impact. Roth likens the recharacterization maneuver to an option: The initial conversion allows the investor to buy out the government's ownership of the IRA (essentially, the taxes due) at a given level while retaining the option to do it all over if a lower tax bill would result. Roth says, "The recharacterization is an option and, like all options owned, volatility makes it worth more." Roth outlined some other conversion- and recharacterization-related strategies in this article, including the idea of maintaining separate Roth IRAs to exert an even tighter level of control over conversion-related taxes.
Investors intrigued by this strategy will also need to mind the deadlines and rules regarding tax reporting. This IRS series of FAQs provides the major details, but investors who are considering a conversion or recharacterization should also talk with a financial or tax advisor to ensure that they're thinking through their personal variables.
